Here's What Venture Capitalists Want To Fund In 2015 - And What They Don't

It's a head-spinning time for venture capitalists. This year, they're continuing to get disrupted by upstarts from angel investors to new giants like Andreessen Horowitz, yet they also enjoyed the most initial public offerings since 2000, including several this week. Then late this year, things cooled off along with the stock market.

So you might think they're a bit cautious about 2015. But they're not--at least not most of the VCs on a panel today in Menlo Park, who provided some insight into what investments they like and maybe more important, which they don't. On the panel were George Zachary, a partner at Charles River Ventures and an early investor in Twitter and Yammer; Kent Goldman, founder of new seed-stage investment firm Upside Partnership, which counts the founders of the companies it funds among its limited partners; Sergio Monsalve, a partner at Norwest Venture Partners; Scott Raney, a partner at Redpoint Ventures; Ullas Naik, founder of Streamlined Ventures, another seed-stage fund that has invested in Sidecar, Nuzzel and iRobot; and moderator Harold Yu, partner at the panel host, the law firm Orrick, Herrington & Sutcliffe.

Anyway, why aren't they too worried about next year? Mostly because the Federal Reserve is keeping the slight breeze at the back of the economy going. "Everyone in this room is the lucky recipient of the Fed’s model of essentially giving us all no yield," said Zachary. "It’s terrible if you’re a saver, but if you own equities, it’s really great and that’s what drives Silicon Valley."

They aren't even too worried about valuations of startups like Uber, which recently got funding at a stunning $40 billion valuation. But the high valuations aren't across the board. "Valuations range from high to extraordinarily high," said Raney. "But there’s a real dichotomy: ridiculously high valuations in some cases, balanced by a lot of rational behavior in the public market. That will provide a dampening effect that will prevent absolutely ridiculous things from happening."

Next year, anyway. The year after next is another story. Most of the VCs sounded really worried that the economy, in particular their high-valuation corner of it, is headed for trouble in 2016. For one thing, it's an election year, which means lots of uncertainty. But even before that, there are signs of a "plateau," said Zachary. "Look at profit to sales for the entire market and divide it by the GDP of the U.S. Other than in 2000, this year is the highest number since 2007. So that says we’re at the highest P to sales. It’s no coincidence that Warren Buffett has $50 billion of available capital."

Meanwhile, late-stage investors are ponying up big bucks on some high-profile companies for "fear of missing out." Another sign of a top, said Monsalve: Waiters' favorite show is Shark Tank. When entrepreneurship looks glamorous to the general public, he said, investors should be worried.

And there are signs of a plateau in some tech sectors already. App fatigue, for example. "The good thing I see more founders taking on more computer science problems," Goldman said. "One entrepreneur pitched a new non-Von Neumann architecture computer."

The excess funding is worrisome for startups, too. For one, it makes them sloppy. "The thing that could make all this unwind is companies spending more money than they need to because they raised big glory rounds," said Raney. "Little by little it’s creeping in." That's especially dangerous when a company's product doesn't really fit the market they're selling into. "Some companies go on this endless journey to figure out what to do and it’s miserable," Zachary said. "Starvation is the best motivator of focus. Once you find product market or the ability to scale revenues, then adding fuel to the fire is what you should do."

The other problem: There's not enough talent to staff the startups VCs are overfunding. "The one limiting reagent is high-quality people," said Monsalve. "If the IPO market continues and Google, Facebook, and Uber keep hiring, the big issue will be the ability to attract talent. That’s been the biggest limiting growth factor for us." As a result, he and others are looking to New York, Los Angeles, India, China, even France and Sweden for engineering teams. There's also a shortage of operational talent, said Naik. "These days I’m finding a lot of founding teams that are drifting because they don’t have appropriate governance and operating discipline. We’ll see a lot of these startups fail."

OK, economic preliminaries aside, where are the VCs looking to invest--or not? One signal of the latter came when Yu asked what word each would like to erase from the dialogue in 2014:

Later, in response to audience questions, they added more to their no-no list:

* Ad tech. "The public market believes Google, Facebook and Twitter will dominate online advertising," said Zachary. "Every ad tech company faces the same circling-the-drain problem. Rocket Fuel ran out of fuel. There is no tech in ad tech, it’s mostly ad networks. We advise ad tech companies to sell out."

* Energy. "I invested in clean tech in 2006 to 2008," Naik admitted. "I was part of that wave of people who didn’t know what we were doing. I got hurt. I do believe the opportunity exists, but I have not figured out how to solve the capital intensity problem." Neither has anyone else. "We have one renewable energy company, Terra Power," said Zachary. "It was a seed investment of $20 million. Bill Gates put in $19 million, we put in $1 million. I have no idea how it works. (Someone in the audience answers him: 'It burns cash.') Bill has agreed to buy us out at an astronomical valuation, so we said, Why not?"

* Space. "I’ve been best friends with Elon Musk for 20 years, so I’ve been kicking myself for 10 years," Zachary said. "Peter Diamandis is doing a lot of work and it looks pretty interesting. The question is in what time frame."

George Zachary

Lest you think they aren't interested in anything, here's what they are investing in:

* Big data. Naik, for instance, invested in Tachyus, which uses sensors and other technology to help oil and gas producers improve production. Raney is interested in the combination of Software As A Service and data-driven software, because he thinks SAAS companies realize they’re sitting on a treasure trove of data that they can leverage. Infer is one company doing this, helping to improve sales productivity.

* Marketplaces. Monsalve said he has always been fascinated by two-side marketplaces. Two companies in this area are Udemy, in education, which has a powerful experience for consumers and for producers, and Lending Club, which goes public this week.

* Bitcoin. Even though he got sick of hearing about it this year, Naik thinks it will become a legitimate application for currency. "In a year, we’ll be past the hype," he said. (We'll see.)

* Mobile. Raney thinks there are still lots of opportunities in mobile, such as deep linking in apps. But he still thinks most will sell out to bigger companies.

* Education. But only companies dealing directly with students or parents. Udemy, for instance, said Monsalve, is more focused on parents doing things on their own. For his part, Zachary's interested in "changing the world of training people." He's an investor in Udacity, which he said is starting to scale up after some rough patches.

* Who knows? A couple of VCs said they invest in passionate entrepreneurs rather than a particular technology. "If you want to do seed-stage right, you have to be in a place where you can’t see a market yet," said Goldman. "I look for people who can tell me a story on why the company they’re building now is the exact right one to build right now and why they’re the ones to build it."

Zachary agreed. "Sectors are an illusion. My only algorithm is 'Would I want to join these people as a founder?' It’s more than investing your money, it’s investing your life." For instance, he invested in Cotap, founded by the former engineering team of Yammer.